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Definition: Compensating Balances Plan
Compensating Balances Plan is a plan which under which an insurance company or insurer receives a premium from the insured customer in a separate account. The customer can withdraw the amount from the account for various usage purposes. The account may or may not be interest bearing.
A company requires cash for its operations. The need may be for daily transactional purposes or for speculating purposes. The need for working capital changes requires cash in company’s hand/current account so that it can fulfil its current obligations. Hence the company’s maintains an account with an insurer. After calculating the cash budgets, the company must fill in the shortage amount in the account if the balance in the account runs below the balance requirement. The company normally pays a premium as per the plan to the insurer. And insurer puts the money into an account with the bank, under his own name. But the bank allows the insured to take out the money from the account as money is recognized as compensating balance of the insured. Through compensating balance plans, a company fulfil its immediate cash requirements and is able to avoid the high costs of short term finances.
For Example: If a firm has a compensating balance plan with an insurance company requiring firm to pay a premium of Rs 50,000 annually since last 36 months. Hence the premium collected until now will add up to Rs1,50,000. So now if the firm needs an immediate cash, it can take out the cash from the compensating balance account with the bank that insurer has opened account with.
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